How Banks Work

Commercial banks serve as the primary financial intermediaries in modern economies, operating financial settlement rails, taking customer deposits, and allocating credit across private households, corporations, and public entities. By transforming short-term, liquid deposit liabilities into long-term, illiquid loan assets (maturity transformation), commercial financial institutions generate credit and drive economic activity.

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|                  COMMERCIAL BANK BALANCE SHEET                  |
|                                                                 |
|   ASSETS                              LIABILITIES & EQUITY      |
|   - Cash & Central Bank Reserves      - Demand Deposits         |
|   - Investment Securities (Treasuries)- Savings & CD Accounts   |
|   - Loans (Mortgages, Commercial)     - Wholesale Repo Debt     |
|   - Fixed Capital & Premises          - Tier 1 Equity (CET1)    |
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Balance Sheet Intermediation and Reserve Mechanics

A commercial bank's operation is defined by its balance sheet structure, governed by double-entry accounting where total assets must equal total liabilities plus shareholders' equity:

• Bank Assets: Yield-generating instruments including consumer mortgages, commercial real estate loans, syndicated corporate credit, revolving credit lines, government Treasuries, mortgage-backed securities (MBS), and reserve balances held at the central bank.
• Bank Liabilities: Customer demand deposits, savings accounts, certificates of deposit (CDs), federal funds purchased, and repurchase agreements (repo borrowing).
• Bank Equity Capital: Common Equity Tier 1 (CET1) capital, paid-in surplus, and retained earnings, which absorb loan write-downs and asset mark-to-market losses.

Fractional Reserve Systems and Credit Creation

Under a fractional reserve banking system, commercial financial institutions maintain a fraction of deposit liabilities in liquid reserves (cash in vaults or reserves held at central bank facilities). When a bank extends a new loan, it does not simply re-lend existing physical currency; rather, it creates a new deposit liability on its balance sheet, expanding broad money supply ($M2$).

$$ ext{Theoretical Money Multiplier } (M) = rac{1}{ ext{Reserve Requirement Ratio } (RR)}$$

In modern monetary systems, credit expansion is constrained primarily by regulatory capital requirements (such as Basel III equity ratios) and borrower creditworthiness rather than reserve ratios alone.

Revenue Models and Net Interest Margin (NIM)

Commercial banks derive revenues from interest rate spreads and non-interest financial service fees:

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|                  NET INTEREST MARGIN (NIM) FORMULA              |
|                                                                 |
|   NIM = ( Gross Interest Income - Gross Interest Expense )      |
|         --------------------------------------------------      |
|                      Total Average Earning Assets               |
|                                                                 |
|   Historical NIM Range: 3.00% - 3.50% across commercial banks   |
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Net Interest Income

Net Interest Income (NII) represents the difference between interest earned on loans/securities and interest paid to depositors and wholesale debt holders. A bank's operating efficiency is measured by its Net Interest Margin (NIM):

$$ ext{NIM} = rac{ ext{Interest Income} - ext{Interest Expense}}{ ext{Average Earning Assets}}$$

When central banks raise policy benchmark rates, banks reprice floating-rate commercial loans faster than customer deposit rates, temporarily expanding NIMs. For an analysis of policy rate dynamics, see How Interest Rates Work.

Non-Interest Income

Banks supplement NII with fee-based non-interest income:

• Wealth management and private banking advisory fees.
• Investment banking underwriting fees and M&A advisory.
• Credit card interchange fees and wire transfer transaction charges.
• Payment processing and merchant acquiring services.

Banking Regulation and Prudential Supervision

Because commercial banks manage liquid public deposits against illiquid long-term assets, they face liquidity risk, credit default risk, and interest rate duration risk.

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|                    BASEL III REGULATORY BUFFERS                 |
|                                                                 |
|   - CET1 Capital Ratio : Minimum 4.5% + 2.5% Conservation Buffer|
|   - LCR (Liquidity)    : High-Quality Liquid Assets / Outflows  |
|   - NSFR (Funding)     : Available Stable / Required Funding    |
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Regulatory frameworks maintain system stability:

1. Basel III Capital Framework: Mandates minimum Common Equity Tier 1 (CET1) capital ratios of 4.5% of risk-weighted assets, plus a 2.5% Capital Conservation Buffer (totaling 7.0%), protecting institutions against credit write-downs.
2. Liquidity Coverage Ratio (LCR): Requires banks to hold unencumbered High-Quality Liquid Assets (HQLA)—such as central bank reserves and sovereign Treasuries—sufficient to cover 30 days of net cash outflows during a severe liquidity stress event ($ ext{LCR} \ge 100%$).
3. Net Stable Funding Ratio (NSFR): Forces banks to maintain a stable funding profile relative to the composition of their assets over a one-year horizon ($ ext{NSFR} \ge 100%$).
4. Deposit Insurance: Entities like the Federal Deposit Insurance Corporation (FDIC) in the US insure deposit balances (up to $250,000 per depositor per insured bank), preventing bank runs driven by retail depositor panic.

Regulatory compliance requirements are detailed in regulatory compliance. Modern digital banking innovations are covered in fintech and financial market integration in financial services. Debt instrument structures are analyzed in the global bond market guide.

Understanding credit creation, balance sheet duration management, and prudential supervisory standards remains central to evaluating how banks work.